Choosing the right business classification is critical to the success of your business. This article is for entrepreneurs & small business owners who are trying to decide whether they should structure their business as an LLC or S Corporation. Let’s dive into the differences and figure out what is best for you.
- An S corporation isn’t a business entity like an LLC; it is an elected tax status.
- LLC owners must pay self-employment taxes for all income. S-Corp owners may pay less on this tax, provided they pay themselves a “reasonable salary.”
- LLCs can have an unlimited number of members, while S-corps are limited to 100 shareholders.
When starting a business, you have several types of business entities to choose from. LLCs and S Corporations are among the most popular of choices, but they differ in many ways in taxes and management structure. In some cases, a business can be classified as both an LLC and an S-Corp. Here’s what you need to know before you decide which option is best for your business.
What is an LLC?
An LLC (Limited Liability Company), is a business structure that protects the personal assets of the business’s owners (also known as members). If the business gets into legal troubles or is sued by a debt collector, the plaintiff or creditor can only go after the business’s assets. The personal assets of the LLC owners are completely protected.
If the LLC is taxed as a Sole Proprietorship, it has the tax advantages of being a pass-through entity. This means that the company’s profits “pass through” the business to the LLC members. Members can then report the profits on their personal tax returns rather than filing a corporate tax return. The LLC members must pay self-employment tax on their income.
Alternatively, an LLC may be taxed as an S-Corp, which means the member must be paid a reasonable salary, which the LLC reports as a business expense and deducts payroll taxes from. The business’s remaining profits are distributed as dividends.
Key Point: An LLC shields the personal assets of the members from business creditors. It is a pass-through entity, so LLC members report earnings on their personal tax returns.
What is an S-Corp?
An S Corporation (S-Corp or S Subchapter), is a tax election that lets the IRS know your business is taxed as a partnership. It also prevents your business from dealing with double taxation on a corporate level. To become an S-Corp, your business first must register as a C Corporation or LLC.
In an S-Corp, the business owners are shareholders. As the owner, you are considered an (W2) employee of the business and must pay yourself a ‘reasonable’ salary. An S-Corp’s profits, losses, deductions and credits are all taxed at the shareholder level.
To qualify as an S-Corp, your business must have 1-100 shareholders. Your business must also be located in the United States, and you must file with the IRS as an American Corporation.
Key Point: An S Corporation is not a type of business – it is a tax election. The tax liability of S-Corp, Sole Proprietorships, or Partnerships belongs to the members or shareholders. An LLC may also file as an S-Corp.
What are the differences between an LLC and S-Corp?
Small business owners often choose to structure as an LLC because it offers more freedom than corporation structures. But before making this critical decision, it’s important to know the differences between an LLC and an S-Corporation.
1) Tax Differences
An S-Corp is not a business entity like an LLC, Sole Proprietorship, Partnership or Corporation. Rather, it is an elected way of determining how your business will be taxed. With an S-Corp tax status, a business avoids double taxation, which is when a corporation is taxed on its profits and then again on the dividends that shareholders receive as their personal earnings.
An LLC can be an S-Corp (or even a C corporation) depending on how the business owner chooses to be taxed. An LLC is a matter of state law, while an S-Corp is a matter of federal tax law.
In an LLC, members must pay self-employment taxes directly to the IRS, which are Social Security and Medicare taxes. Any income an LLC generates is considered taxable income.
With an S-Corp, shareholders are paid a salary and the business pays their payroll taxes, which can be deducted as a business expense from the company’s taxable income. If the business has any leftover profits, they are distributed to shareholders as dividends – which have a lower tax rate than regular income taxes.
2) Management Structure
LLCs and S-Corps are different in management. When members manage an LLC, it is like a partnership (or a Sole Proprietorship if there is only one member). If it is run by managers, the LLC is more like a corporation, as the members are not involved in the daily business decisions.
3) Shareholders, Restrictions, and Stock
S-corps can only have up to 100 shareholders total, while an LLC can have an unlimited number of members. Additionally, S-Corps can’t have non-United States citizens as shareholders, but an LLC allows non-United States citizens to be members.
There are also different subsidiary restrictions. LLCs are allowed subsidiaries without restriction, while S-Corps aren’t allowed to set up any subsidiaries.
Finally, LLCs cannot issue stock, while S-Corps can issue a certain class of stock.
What is better for entrepreneurs, an LLC or S-Corp?
The short answer: it depends. Filing to become an LLC is a great approach to start with, because this structure offers liability protection and tax write-offs. However, as your business grows beyond the beginning startup stage, switching to an S-Corp may make more financial sense. As income from the LLC increases, so do the self-employment taxes.
S-Corps can make more sense financially, but unless there is a specific reason to make the switch, it may not be the best move for a small single-member LLC.
Should I have my LLC taxed as an S-Corp?
The right structure for your business depends on you, other owners, and the business itself. Here are the pros and cons for having your LLC taxed as an S-Corp, as well as general revenue levels to consider in order for being taxed as an S-Corp to make sense financially.
Pros
- The business pays your salary and the payroll taxes on it. This may save you money on taxes because, as with a regular LLC, you would pay self-employment taxes on the business’s gross income.
- Additional earnings are distributed to shareholders as dividends. This may also save you money, since dividends are taxed at a lower rate than income.
Cons
- There is a salary cap as you must establish “reasonable compensation” for owner-employees.
- You’re limited to one class of stock and 100 shareholders.
- Shareholders own more than 2% of the company’s stock and can’t claim employee health insurance as a tax-free benefit as they could do with a C-Corp.
While there are multiple variables, we believe in only having your LLC taxed as an S-Corp when you can personally make over $60,000 a year. This allows you to divide the income between personal income and dividend income, and gets you to a lower overall tax rate. The drawback is that you also have to pay for an individual S Corporation tax return at that point (typically between $1,000-$2,500). That is why the $60,000 annual mark is usually around where that plays out. Before then, it’s best to accept the money as personal income and file Form 1040 on your personal return.
Conclusion
Many entrepreneurs and small businesses set up their new ventures as LLCs to have some legal protection for their personal assets. When your business grows, it is a good idea to speak with a CPA or tax professional and look into filing as an S-Corp for financial benefits. If you need assistance with setting up your business, please don’t hesitate to contact us. Best of luck with your journey, and always remember that Your Business Is More Than A Number.
This information should not be taken as tax advice. Since tax rules change over time and can vary by location and industry, consult a CPA or tax advisor for specific guidance.
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